Financial Features

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16 June 2016

Regulate Payday Lending, But Not Like This

For the first time, the federal government is creating rules focused on the short-term, small-sum credit known as payday lending. That’s a good idea, but the plan announced by the Consumer Financial Protection Bureau isn’t the way to do it.

Payday lenders cater to people with poor credit who need cash fast. Lenders typically offer two-week loans of a few hundred dollars for a 15 percent fee -- nearly 400 percent annualized. Outrageous as those terms may seem, they can make sense for someone who, say, needs to fix a car to get to work and can’t borrow any other way.

But that’s only if the loans are quickly paid back. Often they aren’t -- and that’s how many lenders like it. Paying the loan down gradually is discouraged: Typically, borrowers are required either to repay in full on the due date or extend the whole amount at added cost. Many do just that, paying much more in interest and fees than they initially borrowed, and ending up in deep financial distress. This kind of business accounts for a large share of payday lenders’ revenues.

The challenge for regulators is to curb this predatory lending without killing off a useful service.

There’s a workable model: In 2010, Colorado adopted a rule giving borrowers at least six months to pay down a loan’s principal and capping total charges. Since then, interest rates have fallen by more than half, payments have become far more affordable, and the service has remained widely available.

The CFPB lacks the power to cap finance charges like Colorado did, but it could do something similar. Set a ceiling of gross income -- say, 5 percent -- below which it will presume loan payments to be affordable. This would be straightforward, because payday lenders typically already require a pay stub or other proof of income. A clear and simple rule of that kind could attract traditional banks into the small-sum lending business -- helping to lower annualized interest rates even more.

Unfortunately, the CFPB has proposed a much more complicated -- and much less effective -- approach. This would require lenders to run various checks on borrowers’ ability to pay (and to satisfy other conditions), yet would provide no clear guidance on the permissible level of payments. Complex verification will slow the process and increase the cost, lack of clarity will repel traditional banks, and lenders will be able to keep collecting fees that can add up to more than three times principal over the life of a short-term loan.